The rebalancing of the Chinese economy is analyzed through a heterogeneous taxation of various types of firms across private and public sectors. Based on a two-country dynamic general equilibrium model, the paper applies tax reforms to raise consumption, reduce the investment rate and maintain a high level of welfare.
To rebalance consumption and investment, taxation may allow reallocating a part of the labor force to private domestic and foreign firms. Moreover, the correction of distortions in production factor costs (capital and labor) is necessary during certain reforms applied in the model; that is, on the one hand, higher credit costs for State-Owned Enterprises (SOEs) and, on the other hand, a catch-up of foreign expatriated firms’ wages by domestic firms (public and private).
These consumption and investment reforms bring welfare benefits to households, and the results are close to direct welfare maximization. In this framework, the rebalancing of the domestic demand does not require the readjustment of the external financial position because the aggregate savings rate remains high and the supply of domestic assets is reduced.
Finally, another theoretical framework proposes a heterogeneous taxation of consumption across home and foreign goods to enhance consumption. The main reform that increases consumption is the tax rebate on the domestic consumption of foreign goods. Moreover, we can notice that the government even more uses taxes on consumption as instruments to enhance consumption when nominal rigidities are high. In this other framework, a rise in firms’ credit cost is still a key channel that both reduces the investment rate and increases the consumption ratio (through returns on savings).